At a signing ceremony on Tuesday, June 25, 2013, Governor Jan Brewer signed House Bill 2111, Arizona’s transaction privilege (sales) tax simplification bill, one of her signature pieces of legislation this year. The sales tax simplification bill enacts major changes to Arizona’s sales tax structure, although it falls short of the big, bold ideas its backers initially proposed.
In May 2012, Governor Brewer signed Executive Order 2012-01, establishing the Transaction Privilege Tax Simplification Task Force. The Task Force was charged with evaluating Arizona’s sales tax system and making recommendations on how to simplify the tax system, improve compliance, and reduce administrative burdens on taxpayers. The Task Force consisted of private sector business representatives, government tax administrators, and interest group leaders. It held hearings and meetings throughout 2012, and issued a final report on December 13, 2012, making numerous recommendations for changes to Arizona’s sales tax system. In early 2013, legislation was introduced to implement and adopt many of the Task Force’s recommendations.
During the course of the legislative session, the proposed simplification bill took many forms. Many cities intensely opposed key provisions of the bill, and were successful in changing it throughout the session. After making many revisions and amendments to the bill, the Arizona Legislature passed House Bill 2111, a significantly scaled down version of what was originally proposed, with almost unanimous support in the House (58-1) and the Senate (29-0).
Key provisions of the sales tax simplification bill follow:
Return Filing, Payment, and Audit Streamlining
- Online Portal. In 2012, the Arizona Legislature passed House Bill 2446, which required the Arizona Department of Revenue (the “Department”) to establish a central online portal where taxpayers could elect to report city sales taxes for cities whose sales taxes are not administered and collected by the Department. The portal is scheduled to be up and running by January 1, 2015. House Bill 2111 dramatically expands the online portal. It requires that the portal constitute a single point of contact where taxpayers may obtain all necessary state and city tax licenses, file a single return for state, county and city taxes, and pay all state, county and city sales tax. Previously, taxpayers had to file a return with the Department for state and county taxes, and cities whose taxes were administered by the Department, but taxpayers had to file a separate return with each city that administered its own sales taxes (generally the larger cities such as Phoenix, Mesa, Scottsdale, Chandler, Peoria, and Glendale). Taxpayers who do not elect to report and pay city taxes through the online portal, but instead choose to submit paper returns, are now required to file the paper returns and pay the taxes owed to the Department rather than sending the returns and payment directly to the relevant city.
- Audits. Under House Bill 2111, taxpayers will be subject to a single audit for state, county, and city sales taxes. In short, all audits will be for state, county, and city taxes, regardless of whether the audit is conducted by the Department or a city. Cities will be permitted to conduct audits of taxpayers engaged in business in only one city, and the Department will conduct audits of taxpayers engaged in business in multiple cities (although the Department may specially authorize a city to audit a multi-jurisdictional taxpayer on request). All audits will be performed in accordance with the Department’s audit manual, and the Department will train all state and city auditors. Appeals of all audit assessments must be directed to the Department, and the Municipal Tax Hearing Office (which previously heard city sales tax cases) will disappear.
Sourcing Rules and Non-Resident and Foreign Sale Exemptions Repealed
- Sourcing rules for transactions involving tangible personal property. House Bill 2111 clarifies the sourcing rules for transactions involving tangible personal property. Gross receipts from retail sales are sourced to the seller’s business location if the seller receives the order at a business location in Arizona or to the purchaser’s location in Arizona if the seller receives the order at a business location outside of Arizona. Gross receipts from leasing or renting tangible personal property are sourced to the lessor’s business location if the lessor has a business location in Arizona or to the lessee’s address if the lessor does not have a business location in Arizona (and the gross receipts are taxable when the property is shipped or delivered in to the state).
- Repeal of exemptions. Current law contains an exemption for sales of tangible personal property to a non-resident of Arizona if the property is shipped or delivered to the purchaser outside Arizona for use outside the state. Ariz. Rev. Stat. § 42-5061(A)(14). Under House Bill 2111, this exemption is limited to sales of motor vehicles only. House Bill 2111 also repeals the current exemption for sales of tangible personal property shipped directly to a destination outside of the United States for use in a foreign country (currently, Ariz. Rev. Stat. § 42-5061(A)(35)). Such foreign sales are not taxable under the foreign commerce clause of the US Constitution and evidently the Legislature thought that a separate statutory exemption was unnecessary.
Prime Contracting Changes
- General structure unchanged. Under House Bill 2111 as passed by the Legislature and signed by the Governor, the general structure of the prime contracting classification remains intact. Prime contractors are still taxable on 65% of their gross receipts, subcontractors are exempt, and sales of building materials to prime contractors or subcontractors are exempt. The initial version of the sales tax simplification bill would have repealed the prime contracting classification entirely and would have simply required contractors to pay sales tax on the purchase of building materials. This proposal met with strong opposition from high-growth cities who wanted the tax revenue from construction within their jurisdiction rather than having all the tax revenue go to cities where material suppliers were located. The second version of the sales tax simplification bill, intended to placate the cities, repealed the prime contracting classification at the state level (except with regards to highway, street, and bridge construction), while still allowing cities to tax commercial and residential construction (as well as highway, street, and bridge construction). Ultimately, neither of these early versions of the bill gained enough traction to get through the legislature.
- Service contractor exemption. House Bill 2111 creates a new exemption under the prime contracting classification for “[t]he gross proceeds of sales or gross income derived from a contract with the owner of real property for the maintenance, repair, or replacement of existing property if the contract does not include modification activities.” The bill specifies that each contract or project is independent from other contracts, and that a contractor who has non-taxable contracts under this new exemption is still taxable on any contracts that include modification activities. In addition, building materials sold to service contractors on exempt projects are taxable. A similar city exemption for service contractors also is added.
- Project specific exemption certificates. In order to reign in abuse of exemption certificates, the Department is required under House Bill 2111 to issue project-specific exemption certificates that contractors can use to purchase building materials tax free. To qualify for a project-specific exemption certificate, the contractor must meet the following conditions: (1) the contractor may not work directly for the owner of the real property, but rather must work on a job that is in the control of a taxable prime contractor; (2) the contractor may only use the exemption certificate for material that will be incorporated into a taxable construction project; (3) the contractor may not have a delinquent tax balance; and (4) the contractor must submit documentation to the Department showing that it meets these conditions. It appears that this new exemption certificate requirement applies only to subcontractors.
- Pre-construction services exemption modified. Arizona law currently contains an exemption for the gross receipts attributable to a “separate, written design phase services contract or professional services contract.” Ariz. Rev. Stat. § 42-5075(N). This exemption is modified so that design phase services and professional services no longer need to be contained within a separate contract. Rather, the terms, conditions, and pricing for the design phase services or professional services merely need to be separately stated from those for construction phase services in the contract.
- Owner-builder classification repealed. The rarely applicable owner-builder tax classification contained in Ariz. Rev. Stat. § 42-5076 is repealed.
The changes made by House Bill 2111 are effective beginning January 1, 2015.
Department of Revenue Implementation
The Department is organizing four working groups to implement HB 2111’s reforms. The Administration group, headed by Lynette Nowlan, Assistant Director – Processing, will focus primarily on payment processing and fund distribution. The Audit group, headed by Tom Johnson, Assistant Director – Audit, will focus on implementing “single audit” provisions. The Contracting group, headed by Christie Comanita, Manager Tax Research & Analysis, will focus on implementing the changes to the sales taxation of construction activities. Finally, the Portal group, headed by Cynthia Ramey, Information Technology Specialist III, will focus on the development and implementation of the online portal. Members of the business community, industry groups, and tax practitioners may participate in the working groups.
House Bill 2111 also authorized expedited rulemaking in order for the Department to promulgate regulations to implement the various simplification measures.